How should you measure returns? Three key metrics and when to use them

Both IRR and TWR are complex to arrive at mathematically, whereas CAGR is relatively easier to calculate.

In India, internal rate of return (IRR), also known as money weighted return, has long been an accepted metric for measuring the performance of an investment. Another measure, often found gracing the cover pages of investment product brochures, is compounded annual growth rate (CAGR).

But as per Global Investment Performance Standards (GIPS), time weighted return (TWR) is the recommended metric to measure performance of all asset classes other than private equity. TWR is also the performance measurement standard required by the Chartered Financial Analyst Institute for managed investment products.

Both IRR and TWR are complex to arrive at mathematically, whereas CAGR is relatively easier to calculate. Period IRR and TWR are extremely tedious to calculate manually, especially for portfolios with regular trading or inward and outward capital flows.

The complexity of these calculations is one of the reasons why most online portfolio services, mutual funds and wealth advisors prefer to calculate and display CAGR.

CAGR measures the lifetime returns of the investment, not the actual returns, and the calculation needed to arrive at it does not take into consideration the various cash-flows during the investment period. Therefore, actual returns would vary from investor to investor, depending on the timing and period of investment.

Measuring an investment or investment advisor's performance based on the CAGR of the product or portfolio is like buying a crate of mangoes based on how the top-most layer appears. The mangoes on top may look ripe and tasty, but the ones inside could be quite different.

What do IRR and TWR measure and how do they differ?

Internal Rate of Return

Measures the actual returns of a portfolio for a given time period.

Considers the original investment value and all cash flows during the period. This includes deposits, withdrawals, gains and losses, which are adjusted for the time value of money.

Reflects all value changes: fluctuating market prices and the decision of the investor and investment manager to add or withdraw funds from the portfolio.

Time Weighted Return

According to the Dictionary of Finance and Investment Terms, time weighted return measures investment performance (income and price changes) as a percentage of capital "at work", effectively eliminating the effects of additions and withdrawals of capital and their timing, which alter IRR accounting.

To put it plainly, TWR -

Measures performance as a percentage of capital invested

Adjusts capital, gains and losses for the time value of money.

Eliminates the effect of capital inflows and outflows from the portfolio. To do so, returns for every sub-period (before any capital contribution or withdrawal take place) are calculated separately and then combined to arrive at TWR, or the return over the total time period.

When to use IRR or TWR

IRR is a useful tool to measure the absolute growth of a portfolio. It is an intuitive metric that visually represents how much the entire portfolio is growing by, and is appropriate to determine whether a portfolio's growth is enough to meet specific financial goals.

IRR is also useful to measure returns from illiquid investments such as private equity. However, since it considers all cash flows, it is significantly affected by the amount and timing of deposits to, and withdrawals from, a portfolio. Such cash flows are not usually under the investment manager's control.

TWR is preferred while comparing an investment manager's performance because it captures true investment performance. It removes the distorting effects of capital inflows and outflows from the manager's portfolio growth.

TWR allows investors to make an apple-to-apple comparison of underlying assets, within the same or different asset classes, by eliminating the effect of capital flows. This characteristic makes it the most favoured metric for measuring performance of liquid investments, where capital flows are frequent.

Since market indices do not consider inward and outward transfers, their performance is measured using TWR. When it is used to measure returns from liquid portfolios, a simple return of market indices can be used to benchmark against.

Whether you are looking at total portfolio performance, an investment manager's report or returns from an underlying asset, it is imperative to understand the meaning of the statistic being quoted in order to determine whether you are applying the appropriate performance metric.